Factors that overcast the growth of Indian IT services companies

BANGALORE, INDIA: The aggregate growth of Indian IT Services companies (14 sample companies) was at 3.0% during Q2, FY2018 (8.1% in USD terms) compared to CAGR of 17.1% experienced over the FY2013-2017 period and a 9.7% growth in last fiscal, FY2017. The lower growth was due to the INR appreciating by approximately 4.0% versus USD during the quarter.

As per Information and Credit Rating Agency(ICRA), Indian IT Services companies are expected to register compounded annual growth rate (CAGR) in mid-to-high single digits for the period FY2017-2020.

Gaurav Jain, Vice President, ICRA, said, “The growth of Indian IT Services companies is impacted by lower demand led by an uncertain macroeconomic environment, lower deal sizes in digital technologies, cloud adoption and high competitive intensity from local as well as international players.”

As for margins, industry’s operating margins have moderated from 24-25% to 23-24% over the last few quarters. With several IT Services players, both local and international, chasing limited new opportunities, price-led competition is likely to intensify and will negatively impact margins.

While companies have increased spending on digital technologies and awarding new contracts, the overall IT budgets have moderated leading to lower incremental spends. “The trend reflects the challenging operating environment characterized by pricing pressure on commoditized IT services, wage inflation, higher onsite costs necessitated by visa curbs as well as lower discretionary spend by corporates,” said Jain.

The industry is driving efficiencies through the deployment of operating levers such as higher share of fixed-price contracts, lesser idle resources, and automation benefits.

However, these factors will provide limited cushion leading to an overall decline in margins from 23.5% in FY2017 to 21.2% in FY2020. IT Services players profitability also remains sensitive to INR depreciation vis-a-vis major currencies such as USD, GBP and EURO and the same too will have an impact.

The credit profile of Indian IT Services companies is expected to remain stable underpinned by its ability to sustain free cash flows despite pressure on revenue growth and margins. With aggregate operating margins of ICRA sample set at 23.5% for FY2017 and 23.0% for H1FY2018 coupled with moderate capex (organic as well as inorganic) and working capital requirements, the free cash flows have remained robust historically. Despite pressures on growth and margins over the medium term, free cash flows are expected to remain healthy, though there could be moderation in the quantum of such cash flows. The credit profile is also supported by net cash position with significant liquidity in the form of surplus investments generated out of past cash flows despite healthy dividend payout and share buybacks.

In terms of verticals, BFS growth has been muted over the last few quarters. Demand for the sector has been adversely impacted by current macroeconomic conditions impacting the industry including sustained low-interest rates and weakening of British Pound as a result of Brexit referendum. The business is supported by digitization efforts, cost optimization, regulatory, compliance and security driven initiatives. The Insurance sector has seen good growth and is supporting the overall growth for BFSI which contributes 30% of ICRA’s sample set revenues.

The Manufacturing verticals (17% of ICRA sample set revenues) outperformed other key verticals with 5.8% growth in Q1FY2018 and 3.6% in Q2FY2018 led by automation including internet of things, analytics, optimising supply chain and enhancing distribution channel effectiveness.

Future Outlook:

The share of Indian players in Global IT Sourcing market stood at 67% in CY2016 (60% in CY2012), however, incremental gains are expected to be at a slower pace, said Jain. Future growth will be supported by higher spend on digital technologies, continued cost benefit offered through outsourcing model and market share gains.

Overall, the credit profile is expected to remain stable over the medium term led by IT Services companies ability to sustain free cash flows despite pressure on growth and margins.

Geo-Political issues restricting movement of skilled labour or increase in minimum salary requirement too will have a negative impact on the sector outlook.

Over the next decade, ICRA also expects consolidation in the industry especially among small and mid-size players as margin pressure will intensify leading to lower returns for shareholders.

‘Indian IT Services companies are in the midst of re-orienting their business models focusing more on higher-end services such as IT consulting and emerging technologies (digital) and have made considerable progress so far, though they still lag behind international peers. We expect large Indian IT companies to grab a higher share of the digital services space over the next three years,” added he.